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Alcatel-Lucent SA (NYSE:ALU)

Q2 2014 Results Earnings Conference Call

July 31, 2014; 07:00 a.m. ET

Executives

Michel Combes - Chief Executive Officer

Jean Raby - Chief Financial Officer

Analysts

Ehud Gelblum - Citigroup

Gareth Jenkins - UBS

Achal Sultania - Credit Suisse

Alexander Peterc - Exane BNP Paribas

Sandeep Deshpande - JPMorgan

Francois Meunier - Morgan Stanley

Stuart Jeffrey - Nomura

Operator

Welcome to the Alcatel Lucent press and analyst conference. We leave the floor to Michel Combes.

Michel Combes

Okay. Good morning and good afternoon to everyone. Thank you for joining us on the call to discuss Alcatel Lucent’s Q2 and H1, 2014 results. As usual, I will start by presenting an overview of our results and our activity before handing over to Jean Raby for a detailed financial review.

Let me start with some introductory remarks on the key developments we observed during Q2 and the first half of the year. First, from a near term market standpoint, we saw operators intensifying their focus on wireless access, pushed by LTE deployments. We perceived this on a broad base, although with somewhat more vigor in North America and in China.

This movement has clearly favored our access segment, notably our wireless access business, which recorded both year-on-year and quarter-on-quarter growth in the neighborhood of 30% in Q2. Such an increase was fueled by coverage and capacity projects.

More specifically in LTE and Small Cells, the two areas where we decided to place our bets, our revenues more than doubled over the first half, while almost tripling in Q2 alone. Meanwhile, demand for high broadband access also led our fixed business to enjoy a solid quarter in revenues and in profitability.

On the other hand, revenue performance in core networking was a bit more mixed. IP routing was down 7% on a very high conversion basis, which I had flagged on various occasions. I will repeat what I say every quarter, namely that one should not over read a single quarter performance, given the viability we may and have already experienced.

To put things into context, Q2, 2014 stands among the top three quarters in routing revenue history. Performance in IT transport and platforms, with revenues also down year-over-year was to a large extent a function of continued transition of the business mix from Legacy to new generation of products and technologies and which by the way end up in an improvement of the profitability of this segment.

The key item I want to stress is profitability. While business mix was skewed towards access in Q2, profitability continued to improve significantly and this is really what I have focused on. This is essentially the result of our relentless focus on costs. At the end of Q2 we have achieved close to 60% of our fixed cost saving targets and our operating income was multiplied by three to EUR136 million.

It is also important to mention that while there may be some temporary movements in operators spending, underlying market fundamentals remain intact. It is our belief that the current spin towards wireless can only be temporary and cannot go without investments in backhaul and core, as the same long term dynamics remains in play, namely the data traffic tsunami if I may call it that way.

To be absolutely 100% clear, I reiterate our EUR7 billion target for core network revenue in 2015 and operating margin of 12.5%, compared to an operating margin for the segment in H1 2014 of 8% and an operating margin for the very same segment in H1 2013 of 4.3%. So we have a sequence which drives us without any issue to the 12.5% that I have mentioned.

Moving to the next slide, this is the fourth quarter since we announced The Shift Plan and this is now the fourth consecutive quarter of constant delivery, which I guess is very critical for an enterprise which is in a recovery story.

First, revenues excluding Managed Services grew 5% in Q2 year-on-year. Second, profitability continued to improve meaningfully, notably gross margin which recorded a gain of 140 basis points to 32.6%, which allows us to post a 32.4% margin on H1 compared to 29.8% margin on H1 last year, and adjusted operating profit which totaled to EUR136 million as I have already mentioned, giving a margin of 4.1%. In total, over the first half, the operating profit increased by an amount exceeding EUR300 million compared to last year.

Third, cost savings of EUR94 million were achieved in Q2, bringing the cumulative amounts since 2013 to a total of EUR572 million. We have now covered close to 60% of the way for our 2015 plan and continue to feel confident that we will hit our savings goal.

This translated into substantial progress in segment operating cash flow. We have a positive segment operating cash flow of close to EUR100 million generated in Q2, up from a negative EUR41 million last year and representing 71% of operating income.

Regarding the Access segment, the outflow of EUR9 million in Q2 was reduced by a more than EUR100 million compared to last year, demonstrating that we are on the right path towards reaching to cash generation as we are committed to do.

Finally, net cash outflow continued to contract, reflecting the operating profit improvement and also valuable compensation, paid in 2014 on the account of 2013. For the record, there has been zero payments in 2012.

Moving to the next slide, I will now provide an overview of our repositioning on IP, cloud and ultra broadband access. Starting with the commercial successes gained across our business line.

IP routing: In addition to our sustained strength in Edge, we continued to progress in core routers, registering four more wins in Q2, including with a major European service provider, bringing the total to eight wins over the first half.

Terrestrial optics: Traction with our 1830 platform continued with more than 480 customers at the end of the first half and already more than 15,000 ports shipped in 100G. Over the first half our 1830 platform represented 43% of optical revenue, compared to 33% last year.

The cloud and virtualization spaces, our SDN solution with Nuage added three commercial wins in Q2, bringing the total to eight at the end of June and momentum continued as well on the NAV front, with more than 55 proof of concepts and trials, including first deployments of virtual RAN software at Mobiliy.

Moving to ultra broadband access, we recorded several important wins in LTE overlay and now manage 55 contracts. Meanwhile small sales momentum remains strong with a total of 71 customers at the end of June.

Fixed Access had a very good first half and continued to add new customers in both copper with VDSL2 vectoring and fiber. So as you can see, commercial traction in the first half was solid, broadly based and aligned with the refocus of our product portfolio.

I would now like to talk about our footprint and our progress with customers. Two things here to gauge our developments. First, the extension of customer reach within our traditional addressable area, meaning the service providers.

Let me highlight a few of our recent wins, including AT&A adding us to their user defined network cloud supplier program, known previously as their Domain 2.0 supplier program, hence extending our long standing relationship with AT&T to the next generation network.

Several wins in virtualization and SDN with notably but also Telefonica, China Mobile, NTT DoCoMo and as I said earlier on, Mobiliy in Saudi Arabia. Good traction in IP core. We have Chorus in New Zealand, Elisa and several others that are not public, including a very major one in Europe. We were recently selected by Vodafone in small cells and added several LTE wins.

Second important building block of our strategy, is diversification outside the service provider space, by addressing new customers, including cable operators and large stake enterprise, including web scale players, as well as adjacent segments.

There it is a complete new territory that we have started to explore. It does take time to make sure to be relevant and have the right product, define the right go-to-market, have wins and start to get traction. In that respect, we are putting the appropriate means and resources to be successful and we already have registered some positive return.

In particular, we recorded first wins in the cable segments for both IP routing, but also Fixed Access and started to extend into the web-scale space. In addition for Nuage, we are able to address the data center area and completely a new set of customers, including but not limited to financial institutions.

Moving now to innovation. We are intensifying our activity as illustrated by these charts that sums up key announcements made throughout the first half of the year. I will give color on just some of them.

As part of the Shift Plan we developed several partnerships as you already know. Our partnership with Qualcomm was announced in September last year and according to plan; we shipped our first small cells in the first half of this year. So it’s not about only announcing, but it’s also about coming in the market in due course, which is very promising.

We announced a partnership with Intel for the virtualization and more recently with Thales in the domain of Cyber Security. We also made two small investments; one, the EBlink started to compliment the distribution architecture of the small cells and one in counter attack around network security.

Looking at our move to the cloud and to the virtualization, you may remember that we had announced a suite of virtualized functions; some already deployed at customers like the virtualized run to Mobiliy. As to our new OSS portfolio, it will also enable us to harness the benefits of cloud technologies with a totally new approach to automating our customers operations.

For Bell Labs, as I said a year ago, we want to have a new engagement model, be closer to our portfolio lifecycle and to innovate its speed and scale. To that purpose, we have recently opened two new Bell Labs locations; one is Tel Aviv, in Israel in the cloud theme and one in Cambridge in the U.K., where we leverage our expertise in video, inherited from the former acquisition of Velocix. Another opening is contemplating in Mountain View in the coming months.

We received a number of prices and awards during the first half. This reflects high quality of our R&D teams and it further encourages to continue focusing on innovation by expanding the role of Bell Labs.

Turning now to the second pillar of shift, restructuring. Let me take you a step back and look at the turnaround in wireless, which is I guess quite illustrative of what we are achieving within the company.

As you know, with the announcement of the Shift Plan last year, we decided to make the best of focusing on 4G and small cells, while at the same time dramatically reshuffle the cost structure, in order to bring the activity back on the path of profitability. Halfway through the Shift Plan I can report very good progress of the turnaround.

First, the best on 4G LTE overlay and small cells resonates well with customers as demonstrated by our commercial traction in North America, China, but also in EMEA and by revenue momentum recorded over the last four quarters.

Second, and this is the absolute priority. Profitability has been in constant improvement over the last quarters on the back of continued cost reduction. SG&A expenses were cut by 12% in the first half; reorganization of R&D spending and notably the increased focus on 4G and small cells.

Over the first half these two technologies represented more than 70% of R&D investments, compared to 60% last year. In addition as you know, we entered into an agreement with HCL to outsource R&D on 2G, 3G.

In total, the message I want to convey today is the message of confidence regarding the execution of the wireless turnaround. We are definitely on the right path to bring the business back into profitable territory by the end of 2015, once all the measures that I have just mentioned will be fully implemented; the last one being when we’ll get the full benefit of the outsourcing of the 2G, 3G that we have just announced.

Now turning to patents, which is also an important piece of the strategy. The planned reimbursement of the secured loan in August is a decisive milestone in Alcatel-Lucent’s turnaround story. By allowing us to regain the full ownership of our patents, it signals to a certain extent the closing of the balance sheet normalization sequence.

We firmly believe that there is a lot of value within our patent portfolio as some of our peers have demonstrated. However, as you know, we inherited from a complex situation and had to restart the business from zero last year. We have delivered on our first commitments, but recognize that ramping up the licensing activity is a lengthy process, requiring notably the right go-to-market approach. We will take the time necessary to extract the base value from our patent portfolio.

In order to achieve this goal, I have the pleasure to announce today, that we will shortly be joined by Laura Quatela. Laura will lead our monetization strategy, bringing a proven track record in IP management, notably in her role as senior executive of Kodak, where she successfully managed the intellectual property of the group, and leveraging on the resources from the IP firm she co-founded. I will personally oversee this role in order to make sure that we deliver as we should in this space.

Turning now to Submarine Cable. Let me tell you right away, it is a strategic decision that we are announcing today. This is not an alternative plan. There is obviously plenty of interest for that business, but we believe it is part and parcel of the group, and we want to grow this activity and to get the benefit of the value creation of this activity.

As you know, ASN is an integrated leader in the telecommunication submarine cables. Integrated means that we design and manufacture the cables, and we also have the marine capabilities to lay and maintain them. In that business our ASN subsidiary is providing to our customers parts of its repeated submarine cables up to 12,000 kilometers; unrepeated submarine cables for regional connections; system upgrades, notably to 100G activating capacity over existing cable systems; and marine maintenance services.

For telecom customers, the demand is driven by capacity and connectivity needs. After the lows of 2013, this telecom activity is recovering and we signed several important wins in the last month, such as Sea-Me-We 5 or EASSy along the African coast.

We intend to reinforce that leadership that ASN has built over the years, as we are clearly the leader on a worldwide basis, and to support its expansion to seize new market opportunities, notably in the oil and gas domain, where we have already recorded early wins like the one recently announced with NextGen, to connect oil and gas production facilities in Northwest of Australia, meaning through communication services, of course to connect those platforms and we foresee market opportunity of the same size as in telecommunication cable, in the oil and gas domain.

Majors in the oil and gas industry now expect to have broadband access for their offshore platforms. Besides we started helping those majors in their subsea engineering operations when wet systems are used. In this context, we are looking at potential investment opportunities to enhance our technology offering and expand ASN integrated solutions portfolio in the oil and gas domain.

We are already in exclusive discussions for the acquisition of a key technology to expand our scope of capabilities for oil and gas offshore. Considering that industrial project, and notably to finance its business development and its diversification, we are then announcing today that we explore the ASN capital opening through an IPO. Such transactions will also increase ASN visibility and optimize capital allocation. We will retain the majority of ownership. Subject to market conditions, we contemplate that IPO to take place first half of 2015.

To conclude, after a full year since we announced Shift, Alcatel-Lucent is in much better shape financially and the turnaround is well on track. As I indicated earlier, with the reimbursement of the secured loan, an important milestone has been passed, and we can now close the first chapter of Shift, which was centered around three priorities:

Defining our playing fields, meaning redefining our product scope, our service strategy and addressable markets. Restructuring; meaning redefining our operating model and setting an aggressive cost reduction plan. Refinancing; meaning fixing our balance sheets. Refinancing is done and now behind us, while restructuring is well underway.

On the first piece, our repositioning is clear and well understood by the customers. We are not yet where we would like to be in terms of diversification of the customer base, but resources have been mobilized and we are in a position to accelerate. Importantly, we are now starting to attract new talents and can address those new areas.

So we are in a position now to open the second chapter of Shift, which focuses on three axes: Innovation: this is all about how we can keep the lead, accelerate the innovation pipeline and enrich our product portfolio. Transformation: with the aim of being lean, agile and constantly adapt to a moving environment. This piece is about culture and processes, with a focus on operational excellence. Growth: with the aim of unlocking growth and expanding our footprint.

In all, I am very confident that Alcatel-Lucent is on the right path to execute its transformation plan and return to profitable growth and free cash flow generation. So I reiterate obviously all our commitments, but namely to be free cash flow positive in 2015.

We will have the opportunity to share more about this second chapter at our Investor Day, planned next November in the U.S.

With that, I hand it over to Jean.

Jean Raby

Thank you, Michel. Going to the second part of the book, given we are already nearly halfway through the call, I will try to make my comments brief and not address points that have been addressed already in one way or another by Michel.

So bringing you to slide 16, it’s the top part of the P&L. We talked about revenues. I’ll speak about the gross margin; the improvement, 140 basis points reflect fixed cost savings, as well as improved gross margins in certain business lines and those elements more than offset what we have flagged before, which is the relatively dilutive impact on margins of the LTE rollout in China, which represent a greater proportion of our revenues than in the past.

Our H1 gross margins were 32.4%, which is an increase of 260 basis points, reflecting an improved mix, as well as of course our fixed operations cost savings. In terms of savings, let me draw your attention to OpEx. They are down 9% year-on-year in Q2.

Within that, let me be granular on SG&A. They are down 14% in the quarter, but within that, G&A expenses are actually down 16%, which I think reflects the strong focus we have on corporate functions, while striking the right balance between cost savings and the needs of the business in sales and marketing and R&D of course.

Overall, our SG&A ratio declined 130 basis points to 12.1%, which actually brings now close to or at the level of our peers, substantial progress from where we were not even a year ago.

In terms of overall fixed cost savings, what does this mean? We have generated EUR94 million in Q2, bringing the total for the year to EUR237 million. We have said that for 2014 you should expect a small third of our cost saving objectives initially set at EUR1 billion in at constant comparable parameter, more like EUR950 million.

We stand by the assessment. Of course, we had translated that into EUR250 million to EUR300 million. I think it’s fair to say you could assume we are going to be in the upper-end of that range. That reflects continuing efforts on costs savings, but also certain discreet commercial initiatives, notably in channels, in order to move towards new segments. In order to improve our customer mix, and move away from our traditional customer expanse area, our customer base, to non-service providers.

Operating income was EUR136 million in Q2, an improvement of EUR91 million, essentially driven by performance in our access business. Overall, our operating margin for the quarter was 4.1% compared to 1.3%, so nearly triple the operating margin in Q2, 2013.

Moving onto the following slide, this is the P&L below the operating income line. Let me draw your attention to a couple of things. One, I’ll leave aside the impairments of assets in Q2, 2013, which skews of course a little bit the comparison.

More interestingly, I want to draw your attention to first, the significant increase in restructuring charges in Q2 2014. That actually reflects the advancement we have in our restructuring program, having basically completed the process of discussions with the unions in most European countries. Therefore, that allows us to record that charge in Q2, for an actual implementation through cash payments in the following months.

In financial result, you should note two trends. One is the lower finance costs, which are starting to, but not completely reflect the significant actions we have taken in our balance sheet, and that’s more than offset by an accelerated amortization of the issuance fees, ahead of the schedule reimbursement of our secured loan; Michel talked about it. We see that reimbursement as another positive element in our debt restructuring.

Let me move onto the following slide, which gives revenues by region. North America is down 2.6% year-on-year; 1.8% for H1. Europe, excluding managed services shows significant growth in Q2 plus 6%, and that’s notably in Western Europe. Eastern Europe remains under pressure.

APAC, of course the story is partly a, if not mainly a China story, up 68% year-on-year in Q2. Japan, which is quite strong, you may recall and I had flagged it in Q1, is actually more flattish in Q2. The Rest of the World remains under pressure, with Middle East and Africa declining slightly, while CALA remains under pressure, notably in Mexico and to a much lesser extent in Brazil.

Moving onto the core networking segment analysis. Michel talked about the revenues of each of the line items. I will not dwell in it. I just would like to draw your attention to the fact that on an operating margin basis we are at 9% for Q2, 2014, for H1 at 8% and when you think about our 12.5% objective, well you can see that we are making significant progress and in a colloquial manner we could say that we are at least halfway there.

In segment operating cash flow, we also see a EUR103 million positive number, improvement in percentage of revenues by 60 basis points. In terms of KPI’s, Michel referred to them. I will not expand more.

So moving onto the following slide, which is access. We’ve talked about wireless, a significantly strong quarter of course, plus 28% year-on-year. Very strong growth in LTE in both China and the U.S.

Fixed line also showed some good growth, with demand for copper and fiber generating significant top-line growth, which was partly offset by decline in legacy businesses. You see the decrease in managed services significant, but frankly in line with our restructuring efforts on loss making contracts. And here we show a positive adjusted operating income in stark contrast to Q2, 2013.

Following onto the other slide, on Q2, 2014 cash flow statement. You see the numbers; of course there’s a part related to the improvement in operating income. I’d like to draw your attention to a couple of elements.

First, as Michel said, in the second quarter of 2014, we paid variable compensation in respect of 2013. This does not show in the operating income, but of course it shows in the operating cash flow. That is in stark contrast with the corresponding period in the second quarter of 2013, where in April 2013 we did not pay any variable compensation in respect of 2012, given the results of the group in that year.

We also have an increase in CapEx in second quarter of 2014, which is a reflection of one-offs element in terms of production capacity process and tools developments, and some of our sites restructuring.

Looking at a few items in the first half, segment operating cash flow increased by EUR357 million and restructuring cash outlays as you see are EUR225 million for the first part of the year.

Moving onto the following slide, which is a snap-shot on the refinancing part of the Shift Plan. The next two slides will deal with that. First, just to illustrate through the reimbursement of the secured loan, the improvement we have made. The loan was initially incurred for EUR2 billion in January 2013, at a time where the financial markets were essentially closed and the group would not raise capital in a normal manner on the financial markets. Since then as part of the Shift Plan we have reimbursed part of the secured loan in various tranches and repriced it twice.

Now given the convertible bond offering we have done in June, we are now able to fully reimburse it. That will be done on August 19. It’s not done before that, because there would be a penalty applicable to that. So we are going to implement it in August, and with that the related pledges on patents, as well as shares of certain subsidiaries will be released. Needless to say, this is generating a significant interest savings, not only in 2015, but also already in 2014.

This leads us to the snapshot of our balance sheet. At this very moment, at the end of last year we had net debt of EUR700 million and sizeable reimbursements to contemplate in the following three years; EUR1.5 billion to be exact. Since then we have basically gone to being cash neutral or debt neutral.

The amount of debt reimbursable within the next three years has actually decreased to EUR200 million, and interestingly and more importantly, our average yield, of course benefiting from the zero coupon and a convert, decreased from 6.7% to 4.8% and average maturity has actually been extended. So as far as we are concerned, this closes the refinancing part of the Shift Plan.

Again taking a step back, when we look at the improvement in our business over the past 12 months, which is really the period since the announcement of the Shift Plan, in every single important metric you see here on this slide, you see substantial improvement. I’m comparing the 12-month period July 1, 2013 to June 30, 2014, to the period July 1, 2012 to June 30, 2013, so comparable 12-month running basis.

In that period, gross margin improved by 370 basis points; adjusted operating income improved by EUR750 million; segment operating cash flow improved by EUR600 million; our OpEx decreased EUR350 million; the SG&A-to-sales ratio is now 12.3%, so a decrease of 170 basis points to 14% in the corresponding period; and free cash flow has improved by EUR316 million.

So in that rolling 12-month period we just completed, we had a cash burn of EUR469 million compared to a cash burn in the corresponding period of minus EUR800 million. So again (inaudible) a bit, but nonetheless it’s an interesting measure to have in mind, as we think about our objective for 2015. We’ve gone from minus EUR800 million to minus EUR400 million and the objective is zero. One can say we are halfway there.

So, on this, I conclude on the following slide with our traditional score card on the Shift Plan objective, again taking the same presentation we had used last year. On our own efforts, described as fixed cost savings and disposals. Fixed cost savings were 60% there and on disposals, where I factor in, of course proceeds from part of sales of shares in ASN as part of the contemplated IPO we have discussed, we will be 60% to two-thirds of the way there in our objective of EUR1 billion of proceeds.

Debt re-profiling as I’ve said, we consider it done and debt reduction, of course given the capital increase and the OCEANE being deeply in the money, we remain 80% on the way there.

On this note, I think that concludes my presentation. I was, again, a bit longer than I would have hoped for, but hopefully that leaves ample time for questions. Thank you.

Questions-and-Answers Session

Operator

Thank you, sir. (Operator Instructions). The first question comes from Ehud Gelblum from Citigroup. Please go ahead.

Ehud Gelblum - Citigroup

Thank you guys, I appreciate it. Good afternoon. Okay, a couple of things. The China LTE rollouts, Jean you mentioned that they hurt gross margin and that was made up for by the other pieces of business. Can you give us a sense as to the magnitude as China LTE rollouts continue.

How much did that hurt gross margin and therefore how much was made up for by the other pieces? And does that continue into the next quarter and at that same ratio and with IP routing, which is a high gross margin business that was not as good. What were the pieces of the business that actually did the make up for the China LTE rollouts? And how should we therefore be looking at margin into Q3 and Q4? Thanks.

Jean Raby

In terms of margins for LTE rollout in China, I will not comment specifically. As you know, we have taken the position that granularity on this was not appropriate, so we are communicating on trends, but it is not the intension to go beyond that. In terms of particular business lines which have contributed to offsetting that impact, you can think about fixed networks, you can think about transport, and you can think about platforms, and routing of course remains at a high level in terms of margin.

Ehud Gelblum - Citigroup

Okay. Can ask a follow up, which is the weakness that you’ve seen now in the core business, how long do you expect that weakness to continue?

Michel Combes

I am not sure that I understood the question. Can you just repeat it?

Ehud Gelblum - Citigroup

Sure. So the core networking business, that was weaker at least than we had expected versus our numbers and versus most street numbers, you were weaker in core networking but stronger in access. How long do you expect the weakness in core networking to last, before it comes back up again?

Michel Combes

I guess I have been – I hope very clear in my introductory remarks concerning the core network in terms of performance, which is completely conjunctural on the quarter – I’m going to come back on this one. And which comforts me on the fact that I have no doubt on our ability to reach the target that we have of EUR7 billion revenue for core networks in 2015.

So with a little bit more of granularity in order to make sure things are clear and you understand the rationale behind these commitments. Routing on one side, the market growth remains around 5% to 6% and we continue to take share in core and we’ll progressively enlarge our scope to new customers, meaning on cable operators, as well as on large stake enterprise, as we have decided to diversify our customer base.

So which means that we see these growth rates that we have enjoyed in the past several years, these double-digit growth, remaining for the coming years as we are entering in this new space. There will be seasonality in between quarters, even maybe in between semesters when the customers elect to invest, first, in access rather than in core, but mid to long term, no change whatsoever.

Then, in this space you have also our terrestrial transport business, where we have rebuilt our footprint with our new platform. We managed a decline of legacy and the ramp up of WDM and so we have consult with new wins, such as Verizon that we reported last quarter, and which will start to deliver revenue end of this year, but mainly next year to renew also with growth in IP terrestrial.

In terms of submarine transport, as I have mentioned to you, 2013 was a low end and we are now embarking in a new upward, cyclical phase for undersea cable and that was highlighted by the comment I have made on the new contracts that we have signed.

And last platform, where I also already mentioned that we are in a transition phase due to the clean-up of the product portfolio, but which is coming to an end and when I look at product and services on which we have refocused platform, which is communication services on one side; IMS driven by LTE; customer experience; our motive (ph) business with our OSS business; and last but not the least, our cloud business with CloudBand. We see already growth in these segments, and so progressively it will offset the decline of the legacy services that we are getting rid of.

So all in all, that gives us a very clear path and way forward to deliver the EUR7 billion target of next year.

Ehud Gelblum - Citigroup

I appreciate it Michel. That’s very helpful. Thank you.

Operator

Thank you. The next question comes from Gareth Jenkins from UBS. Please go ahead.

Gareth Jenkins - UBS

A couple if I could. Just one on the submarine networks. Michel, you talked about the bottom of the cycle. I just wondered, I think in your original loan documents you’re talking about EUR700 million of revenue in 2015 with a kind of high 20s gross margin. Is that still on track?

And then just secondly, EUR237 million of cost savings so far. EUR250 million to EUR300 million is the target and you’re saying upper end of the range, but it looks increasingly prudent or conservative at this stage. Can you just give a sense of what the reinvestment is exactly in those areas that you are talking about in terms of enterprise? Thank you.

Michel Combes

So we’ll take the second question first, on cost. I guess that you know me now since a while, so I mean I am extremely comfortable to be at the high end of the range, with what has been delivered already in H1, so no doubt that we have a strong level of comfort there.

As I mentioned in different calls before, this year is slightly different than last year and next year, because we are in the transition of our cost structure. I have referred to some outsourcing deals, for example which have taken place in HR, in finance, in legal and now in some of our legacy products, and when you are in this type of transition, of course you have to cope with two streams of cost.

One, which is the cost of the existing services that you are still providing and the cost of setting up the new platform until these completely disappear. So that’s why I have always said, one big third, one small third, one big third. So I remain there, so very comfortable to be at the high end of the EUR250 million to EUR300 million.

And then on your question on where to reinvest, as I have mentioned, we need to strengthen our go-to-market, for example in new segments such as cable, such as web-scale players, such as large-stake enterprise and of course part of the savings can be reinvested in order to make sure that we fuel the growth by improving our go-to-market strategy in that space. But we will definitively be at the very high end of the range.

On your question concerning submarine networks, I don’t believe that we have given any figure for…

Jean Raby

Yes, actually it’s before the two of us Michel. I think the numbers you are referring to are the numbers disclosed as part of the secured loan initially issued in January 2013.

Of course, as we prepare for the potential IPO of that business, we feel confident about the financial prospects we will be illustrating to the financial markets, but we will do so in due course, as part of the typical process of an Analyst Day at the appropriate time, if we do make the final decision to go to market. Until then, we will remain on the current scope of our disclosure.

Gareth Jenkins - UBS

Thank you.

Operator

Thank you. The next question comes from Achal Sultania from Credit Suisse. Please go ahead.

Achal Sultania - Credit Suisse

Thanks for taking my question. So just on the wireless business specifically, if I look at the business mix in the first half, it seems like you’ve benefited from strength in the U.S. that basically more than offset the negative impact from China LTE rollouts.

I’m just trying to understand like how we should we think about the mix within wireless as we go into the second half? Obviously there will be some slowdown in the U.S. it seems, based on what the carriers are saying there, but China still continues to ramp up materially. How should we think that has an impact on your margin levels for the second half of this year?

Michel Combes

Well, I guess that you made more or less part of the answer in your question, meaning that it’s true that H2 might be slightly different from H1, from a mix point of view; meaning that AT&T and Verizon have clearly flagged that they had a bit uploaded their investment or upfronted some of their investments in H1.

I just remind you with the fact that Alcatel-Lucent is quite different from many, from all the other players in this, in the U.S. meaning that of course Verizon and AT&T are important, but we are also working for the other carriers, namely, one of the big one being Sprint, but not only, and which have not the same pattern for the second half than the one which has been flagged by AT&T and Verizon.

So within the U.S. the mix already could be slightly different. Then the mix in between the U.S. and China; that’s clear that China will continue to roll out their networks and so margin in China is slightly below margin in the U.S. I have also to remind you with the fact that we have also some rollouts outside of the U.S. and China, which are also part of this mix.

Achal Sultania - Credit Suisse

Thanks. And just to follow up on the cash flow, have you given a sense of what should be the cash restructuring for this year, because I think obviously you are trending at a much lower pace in the first half. I think it’s like EUR220 million odd in cash restructuring. Should we see that step up materially in the back half of this year?

Jean Raby

You should see some increase. Whether or not we will hit the EUR700 million target, which we believe we had indicated, I think we had said EUR600 million to EUR700 million, don’t know yet. It depends of course on the speed at which we need to make payments under applicable social laws, and that of course is a bit of a moving target depending on the individuals involved. But you should see some increase in cash outlays in H2 for sure.

Michel Combes

But if I can give just a bit of color there, we have communicated on a total of EUR1.9 billion of restructuring cost for the three years ‘13, ‘14, ‘15. I don’t intend to change today this figure, nevertheless you see with what we have spent in ‘13, what we are spending in 2014, and with what I have mentioned different occasions where we have been able to secure some interesting deals, where we have disposed of some business instead of shutting them down and restructuring them. You can expect that there is some room of improvement in these amounts spent.

Achal Sultania - Credit Suisse

Okay, thanks a lot.

Operator

Thank you. The next question comes from Vincent Maulay from Oddo Asset Management. Please go ahead.

Vincent Maulay - Oddo Asset Management

Yes, hello. Two questions, the first one on gross margin. You expected roughly 32% in 2014, three months ago due to the encouraging Q2 gross margin, which seems to be extrapolable is it fair to talk now about 32.5% in 2014? And regarding the top line, is it fair to expect the traditional pattern in H2, so namely a flat quarter-on-quarter in Q3, plus 15% in Q4, despite a drop in U.S. linked to the same as minus 8% to minus 20% year-on-year in H2 at Verizon and AT&T?

Michel Combes

So, on your two questions, as you know I have never given or taken any commitment on gross margins, because we were presenting our businesses managed for growth, managed for cash. Nevertheless, I have mentioned it, that’s true that we delivered a 31% gross margin 2013 and that I was shooting, if you were to look at the underlying assumption in my business model, to 32% to 33% in 2015, and I have said that 2014 will be in between those two data points, and that’s true that on the last call I mentioned that probably 32% was a fair assumption.

I can accept to say on this call that based on what we have delivered in first half, that the assumption that you are making of 32.5% round for 2014 is a fair assumption. So that’s one point. On the revenue profile, I guess you presented it right. The seasonality should be more or less the same as the one that we have seen in previous years, with different mix, but will be more or less the same.

Operator

Thank you. The next question comes from Alexander Peterc from Exane BNP Paribas. Please go ahead.

Alexander Peterc - Exane BNP Paribas

Yes, thanks for taking my question. I’d just like you to expand a little bit on the carrier spending mix shift we’ve seen in your results, but also it appears that there was a clear emphasis on access at the detriment of core, particularly IP routing. So I’d just like to know how long you think this will last. Is this a passing event or is it a new trend in spending and how will that affect your cash generation going forward, given that you have significantly higher margins in core versus access? Thank you.

Michel Combes

So, I have a very clear view on that one; meaning that the trends which are stated in the industry are very clear; meaning data traffic explosion driven by video. This has not changed and this is even increasing, probably faster than some were expecting, so that’s one. So the underlying trend remains exactly the same.

What we have seen first half, and that’s a bit of a pattern of 2014 is that the service providers have elected to invest massively first in access and slightly less in core networks, and that’s due to the competition that there’s in between the operators. In the U.S. which was driven by Verizon first with its own investment, and with the catch-up mode of AT&T, Sprint, T-Mo and which start also to appear in Europe, for example driven by Vodafone and which is also a bit the case in China, let’s say driven by all the players there, which are also fighting for the best coverage in terms of LTEs.

It’s clear that this investment in access will accommodate the traffic in the access part of the network, but will push for additional investments in backhaul and in core. So which means that it’s really a conjunctural choice which has been made by the operators, and there is no way that this should change this move towards higher investments in backhaul and in core. And our peers in industry have more or less flagged the same.

When you listen to the ones which are purely wireless access providers or the ones which are purely core providers, and I guess that’s where we have the right mix and the right balance, the important point being for me, in access to be really focused on improving the profitability of our business, which we have done, because my commitment is to be cash positive on access.

And what you’ll see on Q2, I mean, we are halfway there, having in mind that we have no change to the benefit of all the cost restructuring that we have engaged with, such as the last one which is the HCL outsourcing. And on the other side which is core, is to capture the growth when the growth is there; meanwhile, delivering our operating profit margin up to the 20.5%, and so that’s what we are seeing as well. So that’s where we stand.

Alexander Peterc - Exane BNP Paribas

Thank you.

Operator

Thank you. The next question comes from Sandeep Deshpande from JPMorgan. Please go ahead.

Sandeep Deshpande - JPMorgan

Yes hi. My question is regarding your 2015 guidance itself. I mean, you’ve seen this trend in access this quarter. I mean, we’ve heard about this trend of access from other players. In your 2015 guidance itself you’ve given only cash flow number for access. I mean you’ve seen a positive development on margin in access in this quarter. Does this translate into some kind of margin associated with that cash flow in 2015?

Michel Combes

I guess I’m not going to change my commitment for 2015. I guess that it is a rating that you have on the access business and which is the right one. When you look at our access business and we don’t give the full granularity, I have provided you with some hint in terms of the wireless restructuring, which was a big one to be delivered, and which is clearly underway with the refocus on LTE on one side, and small cells on the other side and I have told you that we have the path to go where we intended to go.

The fixed business is posting very, very strong results as well, driven by growth, but as well very strong improvements in profitability and on top of that as you know in access, we report as well our revenue in patents, and I told you that I was intending to get additional traction on patents in 2015 now that we have regained the ownership of the patents and that we have strengthened the management team in order to make sure that we capture what can be captured in this area.

So all in all, that’s the reason why with what we have posted this quarter, which shows that in access we are nearly cash neutral. I am very confident for the target of 2015, which is to deliver cash generation above EUR200 million.

Sandeep Deshpande - JPMorgan

Thank you.

Operator

Thank you. The next question comes from Francois Meunier from Morgan Stanley. Please go ahead.

Francois Meunier - Morgan Stanley

Yes, thanks for taking my question. Actually, regarding the pensions Jean, if you could give us your latest thoughts about the potential cash out flow relating to pensions for 2015 and 2016. Thank you.

Jean Raby

In pensions there will be two cash outflows; one related to the lump sum offers that are frankly not the cash outflow of the group, but a cash outflow in the pension funds themselves.

Preparation are ongoing, following our announcement in Q1, that we had received the appropriate authorizations to proceed. That is on track and we expect to launch the offer some time in the first semester of 2015 and of course at the results shortly thereafter. That in all likelihood will result in a substantial decrease in the liabilities, with a corresponding decrease in assets.

In terms of the cash outflows from the company towards pensions, as you recall, there is a substantial part of those outflows that are related to our European plans. I’m pleased to say that given some actions we have taken, we can expect a gradual reduction of that expense over ‘15 and ‘16. I would hope that we will be in the order of magnitude of EUR160 million, EUR170 million as opposed to above EUR200 million as we have been in recent years.

Francois Meunier - Morgan Stanley

That’s very good news. Thank you, Jean.

Operator

Thank you. The next question comes from Johannes Schaller from Deutsche Bank. Please go ahead.

Johannes Schaller - Deutsche Bank

Yes, hello gentlemen and thanks for taking my question. Two if I could. Just firstly on the U.S., a bit of clarification follow up here. One of peers just talked about capacity spend in H1 and the big operators there, which was one of the positive gross margin drivers and also a very strong offset to the China impact in their H1. Just wanted to clarify, it doesn’t look like for you this has actually had a big impact, so how should we think about this?

Then secondly, if you could give us maybe a bit of an update on Latin America; I know that in Mexico we have a bit of a special situation, but then in markets like Brazil for example, when would you expect maybe some more 4G momentum here coming through? Thank you.

Michel Combes

So first, on your comment on the U.S. I have always been cautious on this capacity versus coverage, which let say was very often highlighted by some of our peers. So for us, we never reported precisely on coverage versus capacity, so I don’t intend to do that here today again.

I guess you have seen our performance in terms of LTE in North America and China. Even if we don’t give the details, I guess that with the figures that you have for China you can have a sense of what has been driven by China and what has been driven by North America, and so I don’t intend to comment much more on this one. But again, what you have also to have in mind is that we have the most diverse portfolio in the U.S. of all the vendors in the U.S., due to our exposure to the three major operators, so that’s one.

The second on CALA, I guess that as it was reported I guess by Jean, by me, we face different type of situation in this continent, some better than others, so let’s say the last one which is of course more difficult is for example Argentina. But nevertheless for what you are saying, I guess that Mexico is still a little bit on hold until all the new regulation is implemented in order to figure out how the market will evolve in the next coming quarters. My view is that in any case, as soon as the new regulation will be set up, there will be opportunities to grow.

In Brazil, we have secured some new businesses with some of the local operators, mainly in our IP and transport business in the past few months. There will be some new opportunities again in Brazil as you were clearly referring to. It’s a rollout of new wireless network, so which drive opportunities for us either/or in wireless and additional IP and transport.

Johannes Schaller - Deutsche Bank

That sounds good. Thank you, Michel.

Operator

Thank you. The next question comes from Simon Leopold from Raymond James. Please go ahead.

Simon Leopold - Raymond James

Yes, thank you very much. I just wanted to revisit the forecast for the core network business reaching EUR7 billion in 2015. Clearly, this quarter, I understand the lumpiness doesn’t put you on that trajectory, but it does indicate strong growth. I’m just wondering how you think about the trajectory or the bridge to that target? Are you expecting significant improvement in the back half of this year for the core networking business and if not, how do you think that trajectory rolls out and gives you the confidence in that target for 2015? Thank you.

Michel Combes

Yes, so I probably was not clear enough in my first answer I guess, and I will stick to what I have said in the past few quarters.

So how do we come to the EUR7 billion? That’s based on assumptions in IP routing; transport; platform, which are the three main components of what we have in our core networks.

Routing, there the market growth remains; the underlying trend remains, as I’ve tried to explain. I have highlighted to all of you in the past few quarters that there is a huge seasonality in this business and when I look a little bit of what has happened for example in 2014, in order to deliver the growth that we have delivered, which was a double-digit growth, we had two quarters which were double-digit growth, one which was single, and one which was declining, and that’s what we have seen every year. So these patterns is more or less the same every year, so that’s one.

Second, as I have highlighted, there is this additional item, which is a shift of investment from major carriers in between Access and Core, which is conjectural and not structural, which can shift a bit the profile in between ‘14 and ‘15, but doesn’t change the underlying trend.

So which means that our assumption in terms of market growth; in terms of our ability to gain share in core, which has been proven again this quarter; the assumption in terms of gaining shares in data centers, which has also been proven this quarter with our Nuage success; and our ability to enter in new customer segments such as cable operators and web-scale players, which has also been proven this quarter. So, therefore IP routing, and hence the reason why I’m comfortable on the IP routing.

Terrestrial, no change there. We had mentioned that we would have to go for this transition in between legacy products and the new platform, the 1830, which is underway, which is now representing nearly half, 50% of our revenue, not yet there, and this is going to be reflected in the profile of our growth in optic terrestrial in the next coming quarters, once the legacy business will have reduced its importance within our optics revenue and we have quite strong results in terrestrial transport.

As you know, we have a leading platform on 100G, moving to 200G, and so hence, not all, but major installments are done on this 100G platform, driving to higher bit rates, 200G, and later on 400G on which we have a kind of leading position.

In terms of submarine cable, which is part of the transport as well, the profile is exactly the same that we have mentioned, so meaning that we come from a low in 2013, recovering in 2014 and expanding in 2015. That was based on assumptions in terms of contract awarded, and among the main ones being the Sea-Me-We or the one that I have mentioned in oil and gas, which are coming in as expected. So there are no change in our assumptions.

And last but not least, platform. Platform, I explained day one that we would go for this transition to reposition platform on communication services, on customer experience and on cloud. Again, those three bits and pieces grow in H1 double-digits and not completely offsetting yet the decline that we have in our legacy services, but again that will turn positive in 2015.

So, that’s where the assumptions are and which give me the comfort to tell you that we are on track for this EUR7 billion.

Simon Leopold - Raymond James

Thank you.

Operator

Thank you. The next question comes from Stuart Jeffrey from Nomura. Please go ahead.

Stuart Jeffrey - Nomura

Thank you. I just wanted to follow up on that last question. Talk about structurally there having growth in the Core as Access traffic picks up. But I guess if I look at the U.S., where that investment in Access has been the greatest over the last couple of years, there’s obviously been quite a lot of scope for the carriers to defer their core investments.

I was hoping you might be able to give a bit more detail as to what it is that’s being sacrificed in terms of the Core Network as they focus on Access? What sort of bottlenecks you are seeing that might give you confidence or that gives you the confidence in the 2015 pickup. What I’m just trying to understand is if the U.S. has managed to not be aggressive on Core investments, why should we assume markets like Europe would be, given that they are someway behind on LTE build-outs for example. Thanks.

Michel Combes

Well, I guess that it would require additional granularity, which it would be a bit long to go through, because of course it depends a little bit of the status of the network in the different countries and what has been already done in backhaul, what has been already done in core for the different operators. And you can expect from us that we have this type of granularity operator by operator, so which is my first answer to this one.

The way this movement that I have highlighted was fully more true this half of the year in the U.S. and in China where we have had this raise for LTE investments and was less true in EMEA, where actually we have had a good performance on IP, meaning that there the battle is not yet on the access and is still on improving the backhaul and the core. So that can depend from one region to the other. That’s also driven by the competitive situation that the operators are facing.

The second piece that I should highlight for the U.S., which has also slowed down a bit the investment, we are exposed of course to the service providers and as I have told you, we have started to enter in cable operators and we have started to have good traction in the past few quarters. There has been a bit of slowdown in the past few months, due also to the consolidation taking place in the U.S. in order for the operators to define exactly the way they want to end their network moving forward.

So there are different bits and pieces which are at stake, which give us clearly the comfort that typically the conjectural piece and discussions with the operators and with their customers give us the comfort that of course the level of investment in IP will remain robust in the next coming quarters.

Again, have in mind that in the U.S. we are not only now started serving the service providers, but we have also this brand new piece of business in cable and web-scale players. So that’s to give you even more granularity of what we are saying.

Last piece as you know, is that we started now one year ago the expansion in core. So we start also to get the benefit of that, but it took some time as we were coming from 0% market share in Core. We have 25% market share in Edge, and so that’s where we are heading to and we as you’ve seen in the number of contracts that we report quarter after quarter, is a good indicator on our ability to overachieve the market figures.

Okay, so I guess that’s probably one hour and 15 minutes in the call. So if you agree, I would like to close the call now; to thank you for this call and happy to speak with you in the next coming months.

Thanks a lot. Bye-bye.

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Source: Alcatel-Lucent (ALU) CEO Michel Combes on Q2 2014 Results - Earnings Call Transcript

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